While some investors want to get involved in picking every stock, and timing their trades just so, others prefer a much more hands-off approach – which is where an index fund can be suitable.
This beginner-friendly option is low maintenance, and can be a great way to ensure your portfolio’s diversity – but they can lack flexibility if you want to get stuck in.
Here, Telegraph Money explains how index funds work, their pros and cons, and how to find the best performers. This guide will cover:
An index fund is a type of mutual fund or exchange-traded fund (ETF) with a collection of stocks that tracks the performance of a market index or benchmark, such as the FTSE 100 or S&P 500.
Like all mutual funds, when investing in an index fund, you are purchasing shares in the mutual fund itself – rather than purchasing the individual securities.
Also, investors buying shares in an index tracker fund are effectively putting their money into a giant pot with lots of other investors. Each investor owns a percentage of the overall portfolio equivalent to how many shares owned, and each investor is entitled to the fund’s returns on that pro-rata basis.
Index funds invest passively, meaning they use a long-term strategy to track a particular market by replicating the selection of securities – usually stocks or bonds – in a portfolio.
They are designed to perform in line with the index and are considered a good option for beginner investors as they are easy to invest in, have low fees and can offer broad exposure and/or diversification.
For example, you could choose to invest in an index fund exposed to the American equity market, tracking the S&P 500, or you could choose an ETF that tracks a physical gold benchmark, offering more niche exposure.
How to invest in index funds
You can buy index funds through your online trading platform – the largest players include Hargreaves Lansdown, Fidelity, Interactive Investor and AJ Bell, but there are smaller brokerage services out there. You can invest by adding the fund to your investment, such as a stocks and shares Isa or self-invested personal pension (Sipp).
You will need to decide on your attitude to risk. There are higher-risk investments with the potential for bigger returns, but these can also be more volatile and therefore carry the risk of large losses too.
There are plenty of tools and quizzes online to help you determine the level of risk you are prepared to take – as even the most cautious investments still carry a risk of capital loss.
The platforms will provide links to index fund factsheets from the fund provider detailing the index they are exposed to, the types of companies and sectors featured in the index – and therefore the portfolio – plus the amount of assets sitting in the fund, and performance history. Remember, past performance is not a guarantee of future results.
If you don’t have an adviser and are not an experienced investor, it may be worth considering how professional help could help you pull together a selection of investments according to your attitude to risk, goals and time frame.
If you don’t already have an adviser or broker you can trust, Telegraph Money’s guide to finding a financial adviser can help point you in the right direction.
You can also find local independent advisers at unbiased.co.uk or visit vouchedfor.co.uk, which allows consumers to rate and review advisers they have used.
Are index funds a good investment?
The answer to this depends on what you want from your investment portfolio, and what kind of investor you are. To help you decide whether index funds might be a good option for you, we’ve outlined their advantages and disadvantage.
Advantages
There are a number of advantages for investing in an index fund:
Easy for beginners – Index funds are considered a convenient option for inexperienced investors as the investment decisions around which stocks or bonds to buy, and how to time buying and selling of these, are taken away. They are simple – sometimes called “plain vanilla” funds – and, as they track the market, investors can view the individual holdings of an index fund on almost any investing platform.
Predictable returns – As index funds track a benchmark or index, they will not significantly outperform this index, or significantly underperform.
Lower fees – Index funds have a much lower turnover, in terms of buying and selling stocks and bonds, than active funds – and this means they have lower transaction fees. They also do not need teams of analysts researching the markets. Therefore, index funds are a lower cost option to active funds.
Tax efficiency – The lower turnover rates in index funds usually result in fewer capital gains distributions, making them more tax-efficient than actively managed funds.
Broad diversification opportunities – There are many different types of mutual index funds and ETFs offering exposure to some part or the whole of one market or index. There are millions of these funds on offer with exposure to a multitude of asset classes.
For example, investors can choose exposure to UK blue chip stocks by holding an index fund exposed to the FTSE 100, or they can choose a more niche or exotic area – such as electric vehicles, physical Bitcoin, luxury brands or companies ranked highest for their diversity and inclusion.
Disadvantages
Lack of flexibility – Index funds automatically hold all the securities in an index, which means they may invest in companies that are overvalued or fundamentally weak. If you were choosing the investments yourself, you could make sure this money is allocated to companies providing better returns.
Lack of downside protection – As they are designed to mirror a specific market, index funds perform in line with the broader market, which can be prone to long periods of downward trends.
No control over holdings – Investors cannot pick or choose what is in their index fund. That being said, this would also be the case if an investor were to buy an actively managed mutual fund.
Market-cap weighting – As index funds mirror an index, they will have the same weighting, or level of exposure, to certain companies as the index. As a result, companies with higher market value, or occupying larger parts of the index as they are big companies, will have a more significant influence on the performance of the fund. This concentration can lead to the fund’s performance being tied to a few large companies, magnifying the risks if these companies underperform.
Disengagement – In an actively managed fund, a fund manager tends to buy a company and work with the management to improve the profits and therefore shareholder returns. Index funds are passively managed, mirroring an index, and do not tend to engage with company management teams.
Best-performing index funds
The table below shows the best performing index funds, using data from Morningstar Direct.
Index funds vs index ETFs
There are key differences between an open-ended index mutual fund and an index ETF:
Index mutual funds pool money to buy a portfolio of stocks or bonds.
Index ETFs are traded on exchanges like individual stocks.
While both allow you to track a stock market or index, they work in slightly different ways.
The price of an index mutual fund only changes once a day – the investment platform collects all the buy and sell orders it has had from investors and calculates this into one new updated price at market close, known as the fund’s net asset value (NAV).
However, as ETFs are traded on the stock market, the prices change in real-time throughout the trading day. It can slightly deviate from the NAV, but investors can also time their transaction purchase or sale of an ETF throughout the day and it takes place straight away.
Investment platforms can offer quite different fees for index funds and ETFs, even if they are tracking the same index.
For index funds, investors are charged a small percentage of the value of the holdings each year, while for ETFs, investors are usually charged a small commission each time they buy or sell.
Another factor to be mindful of is tax: since mutual funds pass on realised capital gains to shareholders, this can create an annual tax liability if gains are realised by the fund manager.
ETFs, meanwhile, have a creating/redeeming structure for creation units as they rebalance, so they’re not exposed to capital gains that would have to be passed on.
Index funds common questions
Are index funds better than stocks?
Index funds are an easier alternative to buying individual stocks within an index – the decision over which stock to purchase has been done for you.
Buying individual stocks can also be more volatile than buying an index fund, which means a chance for higher returns, but also the risk of significantly greater loss.
Are index funds good for beginners?
Index funds are considered a good option for beginners as they tend to be simple, and carry lower fees than actively managed funds. They offer diversification and efficiency in terms of exposure to whole or parts of some stock or bond markets, taking away the need for beginner investors to research individual holdings.
What are the best index funds for retirement?
This entirely depends on where you are in your lifetime and how many more years you have before you plan to take retirement. Generally, investors choosing index funds or ETFs are encouraged to take a long-term investment view.
However, it may be worth considering an index fund that has income units and pays out cash to fund holders as a form of income on a regular basis. Funds offering these dividends include the Vanguard FTSE UK Equity Income Index fund, iShares MSCI Europe Quality Dividend and L&G Quality Equity Dividends ESG Exclusions UK UCITS ETF, to name just a small number of those available.
How much does it cost to invest in an index fund?
Charges are set by the fund or ETF provider and can vary from each portfolio and company.
The main charge is the ongoing charge, which is an annual fee covering operating costs, management fees, performance fees and transaction fees.
Some of the lowest fees on offer are 0.01-0.04pc – Vanguard and iShares have a number of funds and ETFs with this level. In contrast, actively managed mutual funds typically charge between 0.44-0.75pc, but some can be as high as 1pc.
